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“We are no trying to be all things to all people,” says Vanguard’s chief investment officer.

Vanguard, the largest U.S. fund firm with some $1.6 trillion in assets, introduced its first ETF – the Vanguard Total Stock Market ETF (VTI) -- in 2001. It now offers 64 ETFs with aggregate assets of $152 billion.
The company, which is mutually owned by its funds, led the ETF industry in net cash inflows last year, with inflows of $35.4 billion. (This represents about $1 of every $3 invested in ETFs).

In 2010, Vanguard introduced 20 new ETFs, including some benchmarked to S&P and Russell indexes and lowered the expense ratio of seven of its international-index funds.

The firm’s ETFs have an average expense ratio of 0.18%, and the Vanguard S&P 500 ETF features the industry’s lowest expense ratio of 0.06%, according to the company.

A recent report by Morgan Stanley recognized Vanguard ETFs for their precision at tracking their underlying indexes. And the firm was the top-ranked ETF provider in terms of advisor loyalty according to a study released by by Cogent Research in September 2010.

To understand what’s behind Vanguard’s current success in the ETF field, AdvisorOne spoke with Gus Sauter, the company’s chief investment officer, who just returned from a trip to Asia (including stops in Japan, South Korea and Taiwan).
Sauter, 56, joined Vanguard in 1987, two weeks before the Black Monday crash on October 19.

What is Vanguard’s position within the ETF field?

As of today, we have 64 ETFs. The iShares ETFs have substantially more, about three or four times our quantity.

Our approach is different from those of our competitors. We offer broadly diversified products that can be used as building blocks in portfolios rather than more narrowly defined ETFs that investors don’t often make money with, since they are more volatile.

As is the case with more narrowly defined and industry-specific mutual funds, investors tend to get in to such ETFs when the products are reaching new highs and then ride them down.

We were ahead of iShares in terms of net cash flows in 2010. But iShares is still bigger in overall assets, though we are catching up.

We are gaining momentum as we expand the sales force and focus on the product lineup most investors should be focused, like the Total Stock Market Index Fund. It’s really hard to say that U.S. investors shouldn’t be in that. Big blockbuster-type funds should appeal to most investors.

And we’re gaining momentum, primarily with investment and other financial advisors.

What are your thoughts on today’s investing trends, and Vanguard’s relationship with advisors?

This business is always interesting and unpredictable. I cannot recall a time when investing has been s so hard, but when was it easy?

It’s exciting to see ETFs develop, and this has opened up a new marketplace for Vanguard. For our business, it’s exciting to work so much with financial advisors.

Advisors are very much embracing ETFs, which are more convenient for them, since ETFs trades on their equity platforms and thus work perfectly with their [investing] systems.

What level of ETF flows does Vanguard see from investors vs. from advisors?

It’s hard to pinpoint exactly, but roughly 20% of our flows come directly from individuals, and over 50% are clearly through financial and investment advisors. The other 30% is from endowments, foundations, defined-benefit plans, institutions and traders.

How have you established such a strong reputation with advisors?

Most advisors investing in our ETFs share our values and focus on broad diversification, and they’re very concerned about costs and tax efficiency. As they look at all these characteristics, we pass through their screens.

As I mentioned earlier, we have increased sales force and are able to establish relationships with more advisors than before and to help advisors better help their clients.

How does Vanguard keep its costs down?

We’re unique in the fund industry in that we are mutually owned. Thus, with large funds, like the Total Stock Fund, we are able to offer low costs given our huge economies of scale.

This is also true of our fund structure, in that our ETFs are a share class of the existing index fund, which enables us to have critical mass on day one.

Our Total Stock ETF has assets in the tens of billions of dollars vs. the mutual fund with $100 billion. ETFs, in other words, can share in the mutual fund’s economies of scale.

What plans does Vanguard have for upcoming products and services?

We will pursue the same strategy as we expand the product line-up, i.e., offering broadly diversified funds. We don’t plan to roll out a tremendous amount of [new] funds, only those that make sense with some fine-tuning and that allow us to gain further efficiencies and pass them on to investors

Also, we want to enhance the experience that advisors have with us, so we are continuing to build up our sales force and work more closely with advisors. We aim to provide best-in-class thought leadership, and our group conducts thought-leadership work across the entire fund line-up, including ETFs. We’re increasing the number of touch-points and contacts we have with advisors, especially with our sales team, and are looking for ways to help advisors best use our products.

What’s your view on commodity-focused investing today?

I founded a gold mine in the early-1980s in San Bernardino, Calif., and have gotten over that. It took three years to drive it under, so I’m cured now.

We counsel investors that broad-based commodity exposure is prudent. When you drill down to specific metals and commodities, you are speculating a bit more and engaging in undue risk.

We take a broad-based strategy to investing, and I’d be surprised if we offered a gold fund in the future.

How about emerging markets and global investing?

Investments in emerging markets and other international markets are a strong part of our lineup. The Vanguard MSCI Emerging Markets Index ETF (VWO) is the largest emerging-markets ETF in the industry with $45 billion in assets.

Would we slice and dice this more finely? Perhaps a little bit.

We have debated going into country funds, but that’s not our direction. We could, however, take a more regional approach. Investing by country is very volatile, and that’s a counterpart to the industry-specific focus, which is also very hot and cold.

How did Vanguard and its products fare during the ’08-’09 crisis?
Our funds went down, of course. But the good news is that our emerging-market fund, for instance, went down about 40%, which is less than other more narrowly defined products that fell 75%.

Having a broader diversification helped. We didn’t feel good to be down 40%, but it’s a whole lot better than being down 75%.

How can advisors and investors best take advantage of trends without getting too caught up in chasing returns?

People look at past performance and get confused between economic growth rates and the implications for returns, as in the case of China, which is growing 10% and thus looks very attractive.

But investment theory disagrees with this approach. It doesn’t put the two together, because growth is already priced into investments.

This is why we caution investors about the [chasing-trends] approach and recommend that they remain focused on a broader portfolio – rather than throwing caution to the wind and being overweight in emerging markets. We are trying to help investors keep the right perspective vs. getting caught up in the hysteria of a hot investment.

In terms of advisors, there is a bit of self-selection involved: The advisors that gravitate to Vanguard are those that share our beliefs, and this helps further cement our relationship with them while reinforcing their beliefs.

Some advisors likely will not be our client, i.e., those that think they can predict the next hot industry and hence won’t be inclined to invest in our types of products.

Would you like to share any other thoughts on Vanguard and its future in the ETF and fund industry?

Most money is still in the broadest, biggest funds, and we think that will continue to play out going forward. Yes, across the industry, you will see more niche products and many closing down, as well.

We are no trying to be all things to all people… We are just going to enhance our line-up marginally over time, as we find a hole. Thus, we are closer to the end of our product line-up than the beginning.